A Comprehensive Guide on Equi-weighted Portfolio

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A Comprehensive Guide on Equi-weighted Portfolio

An equiweighted market portfolio is an investment strategy that allocates the same amount of money to each asset in the portfolio, regardless of its market capitalization or other factors. This approach has some advantages and disadvantages compared to a market-weighted portfolio, which assigns weights based on the relative size of each asset in the market. In this article, we will explore the concept, benefits, and drawbacks of an equiweighted market portfolio, as well as how to design and evaluate one.



Concept of Equiweighted Market Portfolio

An equiweighted market portfolio is based on the idea of equal diversification, which means that each asset has the same influence on the overall performance and risk of the portfolio. For example, if an investor has 10 stocks in their portfolio, they would invest 10% of their total money in each stock, regardless of how big or small the company is. This way, the investor avoids putting too much weight on a few large-cap stocks, which may dominate the market-weighted portfolio.

An equiweighted market portfolio is different from a market portfolio, which is a theoretical bundle of all the assets available in the market, with each asset weighted by its market capitalization. A market portfolio is used in the capital asset pricing model (CAPM), which is a widely used method for pricing assets and estimating their expected returns based on their systematic risk, or the risk that affects the market as a whole. The CAPM assumes that investors hold the market portfolio, which is the most efficient and diversified portfolio possible.

However, in reality, investors may not be able to hold the market portfolio, as it would require investing in every asset in the market, which may be impractical or costly. Moreover, some investors may prefer to deviate from the market portfolio and adopt different weighting schemes, such as the equiweighted market portfolio, to achieve different objectives or preferences.



Advantages of Equiweighted Market Portfolio

One of the main advantages of an equiweighted market portfolio is that it offers better diversification than a market-weighted portfolio, as it reduces the concentration risk that may arise from holding a few large-cap stocks that dominate the market. By allocating equal portions to each asset, investors can reduce the impact of any single stock on the overall portfolio, potentially improving risk management and stability.

Another advantage of an equiweighted market portfolio is that it may capture the size factor, which is the tendency of smaller stocks to outperform larger stocks over time. According to data from the Kenneth R. French Data Library, the smallest 10% of stocks in the US market did much better than the largest 10% from 1926 to 2020. Therefore, by giving equal weight to smaller stocks, an equiweighted market portfolio may benefit from their higher returns.

A third advantage of an equiweighted market portfolio is that it may be simpler and easier to implement than a market-weighted portfolio, as it does not require calculating the market capitalization or the relative weight of each asset. Instead, investors can simply divide their total money by the number of assets they want to invest in, and allocate the same amount to each asset.



Disadvantages of Equiweighted Market Portfolio

One of the main disadvantages of an equiweighted market portfolio is that it may incur higher transaction costs and taxes than a market-weighted portfolio, as it requires frequent rebalancing to maintain the equal weights. Rebalancing is the process of adjusting the portfolio weights to match the target weights, which may involve buying or selling some assets. This may generate commissions, fees, and capital gains taxes, which may reduce the net returns of the portfolio.

Another disadvantage of an equiweighted market portfolio is that it may expose investors to higher unsystematic risk, or the risk that is specific to a particular asset or sector. By giving equal weight to each asset, investors may end up overexposing themselves to some assets or sectors that have higher volatility or lower quality than others. For example, an equiweighted market portfolio may include some stocks that are unprofitable, overvalued, or in distress, which may drag down the performance of the portfolio.

A third disadvantage of an equiweighted market portfolio is that it may not reflect the true market conditions or expectations, as it ignores the market capitalization or the relative size of each asset. By giving equal weight to each asset, investors may underweight some assets or sectors that have higher growth potential or better fundamentals than others. For example, an equiweighted market portfolio may underweight some stocks that are innovative, profitable, or in high demand, which may boost the performance of the portfolio.



Designing an Equiweighted Market Portfolio

To design an equiweighted market portfolio, investors need to follow some steps:

  • First, investors need to decide on the asset class and the universe of assets they want to invest in. For example, investors may choose to invest in stocks, bonds, commodities, or a combination of them. They may also choose to invest in a specific market, region, sector, or style, or a broad range of them.
  • Second, investors need to select the assets they want to include in their portfolio, based on their criteria and preferences. For example, investors may use screening tools, fundamental analysis, technical analysis, or other methods to filter and rank the assets they want to invest in. They may also consider the liquidity, availability, and cost of the assets they select.
  • Third, investors need to calculate the equal weight for each asset, by dividing their total money by the number of assets they select. For example, if an investor has $10,000 and selects 10 stocks, they would invest $1,000 in each stock, regardless of its market capitalization or price.
  • Fourth, investors need to buy the assets they select, according to the equal weights they calculate. They may use different types of orders, such as market orders, limit orders, or stop orders, to execute their trades. They may also consider the timing, frequency, and size of their trades, to optimize their execution and minimize their costs.
  • Fifth, investors need to monitor and rebalance their portfolio periodically, to maintain the equal weights. They may use different triggers, such as time, threshold, or event, to decide when to rebalance their portfolio. They may also consider the costs and benefits of rebalancing, and adjust their rebalancing strategy accordingly.



Performance of Equiweighted Market Portfolio

The performance of an equiweighted market portfolio depends on various factors, such as the asset class, the universe of assets, the selection criteria, the rebalancing strategy, and the market conditions. Therefore, it is difficult to generalize or compare the performance of an equiweighted market portfolio with a market-weighted portfolio, as different portfolios may have different characteristics and results.

However, some studies have attempted to compare the performance of an equiweighted market portfolio with a market-weighted portfolio, using historical data and simulations. For example, a study by Arnott et al. (2005) found that an equiweighted market portfolio of US stocks outperformed a market-weighted portfolio by 2.7% per year from 1962 to 2004, after accounting for transaction costs and taxes. The study attributed the superior performance of the equiweighted market portfolio to its higher exposure to the size and value factors, which are known to generate higher returns than the market over time.

However, other studies have challenged or qualified the findings of Arnott et al. (2005), by using different data, methods, or assumptions. For example, a study by Hsu et al. (2013) found that an equiweighted market portfolio of US stocks underperformed a market-weighted portfolio by 0.9% per year from 1927 to 2010, after accounting for transaction costs and taxes. The study argued that the equiweighted market portfolio suffered from higher turnover, lower quality, and lower profitability than the market-weighted portfolio, which offset its higher exposure to the size and value factors.

Therefore, the performance of an equiweighted market portfolio may vary depending on the specific portfolio and the period of analysis, and may not be consistent or predictable over time. Investors should be aware of the advantages and disadvantages of an equiweighted market portfolio, and evaluate its suitability and feasibility for their investment goals and risk tolerance.



Conclusion

An equiweighted market portfolio is an investment strategy that allocates the same amount of money to each asset in the portfolio, regardless of its market capitalization or other factors. This approach has some advantages and disadvantages compared to a market-weighted portfolio, which assigns weights based on the relative size of each asset in the market. An equiweighted market portfolio may offer better diversification, capture the size factor, and be simpler to implement than a market-weighted portfolio, but it may also incur higher costs, expose to higher unsystematic risk, and not reflect the true market conditions or expectations. To design and evaluate an equiweighted market portfolio, investors need to consider the asset class, the universe of assets, the selection criteria, the rebalancing strategy, and the market conditions, as well as their own objectives and preferences. The performance of an equiweighted market portfolio may vary depending on the specific portfolio and the period of analysis, and may not be consistent or predictable over time.



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